Paying for Climate Change

For anyone who, like me, is interested in how our global economy will adapt to climate change, there is a must read article in the new york times that addresses many of the questions I raised in a previous post.

First, risk premia have been rising. 

Because of the quickening pace of disaster, those who want insurance or are required to buy it now face much higher costs in risky areas. Premiums for homeowners’ insurance (which covers wind damage) doubled in Florida between 2002 and 2007, tripling in some areas after the 2004-5 hurricane seasons, if insurance was available at all.

Many insurers have raised their premiums because of increased risk estimates, higher cost of reinsurance (insurers transfer part of their risk to international reinsurers), the requirement by regulators and rating agencies that insurers hold more capital in order to reduce the likelihood of insolvency, and the need to provide shareholders with an attractive return.

I speculated that this might be the case, but it appears that rising prices are already occurring. This is the most objective indication that we have that climate change is already underway.

Insurance market prices are effectively representations of distributions. The price of car insurance is a representation of the likelihood that you’ll get into an accident. The distribution for 18-25 year-olds is different than for 30-40 year-olds, and the prices are different. Since our climate is a distribution, insurance price changes for climate-dependent phenomena should be an indicator that the distribution has changed (or, in other words, that the climate has changed).

Assuming that there is a competitive market for climate-dependent insurance in Florida, the evidence cited above is unbiased evidence that climate change has occurred and is occurring. Setting a price too high will mean lost business for the company, and judging by how many people have dropped their wind coverage, this consequence has been suffered by the insurance companies.

Why is this important? In my opinion, it’s that the market is telling us that climate change is happening. Although the scientific evidence is staggering, it has never been quite enough to convince many. Market evidence is rarely cited, and I think it deserves more attention. 

A second point that the authors make is relevant to adaptation: subsidized public flood insurance (i.e., flood insurance that not only is administered publicly, but is also run at below break-even prices), and homeowners dropping other forms of climate-dependent insurance (flood, wind, etc.) is skewing incentives and is promoting increased development and the perpetuation of development in areas that are relatively more exposed to climate risks. This is a problem. The market signals of climate change should be felt and increased prices borne by those who are ultimately exposed to the risks. Why? People need the incentive to move, and as the world changes, our geography and our economy need to change along with it (and, actually, ahead of the changes if possible).